Despite Aggressive Competition, SK Telecom Has Remained On Top

Summary

SK Telecom is one of the world's largest 4G LTE network operators, and has explicitly stated its intention to maintain at least 50% market share.

A new law on handset subsidies should impose more rational behavior on South Korea's mobile operators.

Low and slow revenue growth, coupled with more restrained marketing spend should lead to mid-single digit FCF growth, supporting a $27 fair value and a 4%-plus dividend yield.

As I have written recently in reference to companies like America Movil (NYSE:AMX), Orange (NYSE:ORAN), and NTT DoCoMo (DCM), navigating competition in the mobile services market has only gotten more challenging in most markets. SK Telecom (NYSE:SKM) has the mixed blessing of operating in one of the most difficult markets of all, with KT Corp. (NYSE:KT) and LG Uplus straddling, if not often crossing, the line between fierce and irrational competition in South Korea.

A recent move from regulators to punish all three carriers for violating rules on subsidies impacted first-quarter results, but there's at least a chance that a new rule will eliminate these moves in the future and make competition a little more reasonable. The more rational SK Telecom's rivals get, the better for SK Telecom, and these shares do look a little undervalued today. Combined with a good yield, these shares do hold some appeal on the prospect of better earnings potential in South Korea.

Ruling The Roost… And Determined To Remain So

SK Telecom is the share leader for mobile/wireless services in South Korea, with a little over 50% market share. South Korea leads the world in 4G LTE penetration (over 60% in 2013), and SK Telecom is one of the largest LTE network operators in the world in terms of subscribers. More than half (53%) of SK Telecom's subs are LTE, though that is the norm now in South Korea (almost 70% of LG Uplus subs are LTE).

SK Telecom has drawn a clear line in the sand and declared that it will do whatever it takes to maintain 50% market share. Both KT Corp. and LG Uplus have tested the company's resolve in this matter and found that management means business - SK Telecom will adjust subsidies, roll out new plans, and alter pricing as needed to maintain that market share goal.

While the core of the company is its wireless services, there are additional value-added services factoring into the business. The company's SK Planet is the largest "m-commerce" portal in the world, and the company's Smart Wallet is the most popular electronic/mobile wallet service in Korea. With SK Telecom collecting a small percentage of mobile transactions executed through its portals, services, and mobile app marketplace, it's a nice little additional source of profits.

Paying The Cost To Stay The Boss

Going back to SK Telecom's market share goal, this dedication to 50%+ market share has come at a cost for SK Telecom. The company's operating margin fell about two and a half points from 2011 to 2012, and another point in 2013, falling to a level almost one-third of the 2005 level.

The battles between SK Telecom, KT Corp., and LG Uplus have also sometimes crossed regulatory boundaries. All three companies have resorted to illegal subsidies to attract subscribers, and the government cracked down in March of this year. Instead of prior ineffectual fines, the regulators imposed 45-day bans on signing up new subs on each of the providers. These bans were staggered so as not to overlap, but they seemed to lead more to frenzies of marketing spending ahead of the bans rather than any sort of chastened behavior.

Most recently, the government passed a new handset distribution reform bill that should add a little more rationality to the market. Operators now have to publicly disclose their subsidies (and can be fined up to 3% of sales if the disclosures are not accurate), and handset manufacturers have to disclose any discounting that they may provide. Subsidies will be capped and operators will no longer be allowed to offer different subsidies to customers on the basis of location, usage plan, or so on. Government regulators will also be empowered to enact punishments much more swiftly than in the past.

As handset subsidies have been the primary weapon in the arsenals of SK Telecom, KT Corp., and LG Uplus, this should significantly alter marketing costs for the companies and improve margins. Then again, this is the South Korea mobile market, and I think it would be premature to assume that these companies won't find some new way of pummeling each other in the marketplace. Even so, this change in policy (which goes into effect in October) should benefit SK Telecom and make it easier (and/or cheaper) to defend that 50% market share.

Capital Discipline Is Still A Concern

Like many other mobile operators, SK Telecom has faced the question of what to do with the large sums of capital that a leading mobile franchise can generate. Management hasn't always made the best decisions, as investments made in communications ventures outside Korea generally went badly wrong. Management then turned to investing outside of telecommunications, leading to large ownership positions in Korean companies like POSCO (the steelmaker) and Hynix (semiconductors).

It seems as though management has put a lot of this behind it. The company still owns about 21% of Hynix and still has its SK Telecom Ventures funds, but the company no longer appears to be looking at such ideas as a primary destination for surplus capital. With that, the prospects for higher dividend payments in the future have improved.

Will Better Margins Materialize?

SK Telecom saw 3% revenue growth in its first quarter, with service revenue growing more than 1% on a 5% improvement in ARPU. The company's ARPU should continue to benefit from a higher mix of 4G LTE subs, but I don't expect revenue to grow more than 3% a year over the long term.

SK Telecom also saw operating profit drop 38% in the first quarter, as the company significantly boosted its marketing spending ahead of that 45-day ban. That surge is not going to be repeated again anytime soon, and the new law on handset subsidies should lead to more moderate marketing spending in the future (again, unless these companies figure out a new way around the law and a new way to spend money encouraging subs to switch). I'm cautiously optimistic that SK Telecom will get back on a path to 10%-plus FCF margins, allowing the company to leverage that modest long-term revenue growth into mid-single digit FCF growth.

The Bottom Line

If SK Telecom can generate that mid-single digit FCF growth on a sustained basis, I think fair value is around $27. Coupled with a 4% dividend yield, that makes SK Telecom a reasonably good idea for investors. There are currency risks here, not to mention competitive risks, and SK Telecom alone is probably not the best way to gain exposure to South Korea (broader ETFs are likely a better idea). Even so, in a world where it is tough to find mobile service providers with good operating leverage stories, SK Telecom stands out as a better-than-average option.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.